Should Treasurys fear Japanese pullout?

JulieRannazzisi

NEW YORK (CBS.MW) -- Treasurys got a scare this week that Japan -- the biggest foreign investor in the U.S. government market -- may cool its once-hefty purchases.

Though analysts say these concerns may be overdone in the near-term, Japanese investors may increasingly opt to buy domestic securities instead of foreign ones as the year progresses.

An article in Wednesday's edition of the Nihon Keizai Shimbin, Japan's leading business daily, indicated Japan's five major life insurers will sharply reduce or freeze purchases of foreign currency-denominated bonds this fiscal year -- preferring to shift their funds to domestic assets. That spooked the market and produced a wave of dollar/yen selling.

The article also said that the lifers plan to significantly reduce their purchases of euro-denominated instruments, investing most of their new funds in dollar-denominated issues, which dealt a hard blow to euro/yen.

Should Treasury market players worry? Well, Japan holds about 8 percent of outstanding Treasurys and life insurers are indeed big players, with data from Japan's Ministry of Finance indicating that life insurers were net buyers of 19 percent of net foreign bonds from April 1998 through March 1999, according to consulting firm IDEAglobal.com.

These data suggest that a shift in purchases from the lifers will be felt. Still, strategists say, the brunt of the impact will be in Europe's markets, and not the U.S.

Carl Weinberg, chief economist at High Frequency Economics, notes that the insurance companies will not only be scaling back their purchasers of foreign bonds, but will be paring back their domestic bond buying as well. That's because Japan's wilting economy has caused a reduction in sales of insurance policies, and thus insurers have less capital to invest in the market.

The insurance companies have to respond to this reduction in new policies by decreasing their overseas investments, said David Brickman, international economist at PaineWebber. Japan's recession is the primary factor behind this development, not the attractiveness of foreign markets, he observed.

Brickman also notes that the insurance companies will be siphoning more cash into trust banks, which are heavy investors in foreign securities. That means lifers may diminishing their holdings overseas directly while increasing them indirectly through trust banks.

Japanese investments attractive?

With the U.S. economy forging ahead, does it make sense for Japanese investors to leave their cash in domestic markets? The answer is twofold.

In the near-term, the U.S. will continue to look attractive with 10-year U.S. Treasurys at a yield
TNX, +3.35%
that's 365 basis points over comparable Japanese government bond yields (JGBs). And the juicier yields that can be picked up more than offset any currency risk that Japanese investors incur when investing abroad.

"The risk-reward is still there," Brickman said. Even if the yen continues to strengthen against the dollar, rendering U.S. investments less attractive, he doesn't see the dollar falling below 115 to the yen. See latest currency rates.

Should Japan's currency continue to strengthen, Brickman said, the BOJ would intervene to prop up the dollar as Japanese officials have made it clear they favor a weak yen, which gives Japan's exports a competitive edge.

"Japan's private sector is still contracting," Brickman said. And domestic investors are skeptical of the recent surge in the Nikkei index of Japanese stocks, which has been bolstered primarily by the infusion of foreign cash. See world indices.

As for European debt, the appeal is limited.

Comments from European officials suggesting that last week's sanguine 50 basis point rate slice will be the last one mean European bonds won't have the needed impetus to rally further. Thus, euro markets look less attractive since capital gains on issues purchased won't be obtainable under these circumstances, according to Tony Crescenzi, chief bond market strategist at Miller, Tabak, Hirsch & Co.

Crescenzi said that spreads between U.S. Treasurys and German bunds, for example, are the widest they have been in 10 years, reflecting the cheapness of U.S. issues.

And the conflict in Kosovo will keep the euro under the gun, which will take more polish off of European markets.

Hit by supply

Though the Bank of Japan has been keeping long-term rates low by flooding the banking system with waves of liquidity, it's inevitable JGB yields will go higher due to the avalanche of supply that will be issued this year to fund Japan's fiscal stimulus programs.

Though Japan has temporarily alleviated the pressure by deciding to reduce volume at its regular auctions until June, supply will eventually inundate the market.

"When push comes to shove, you will have to see a rise in JGB yields, and that will put upward pressure on the yen," remarked Ray Stone of Stone & McCarthy Research Associates.

As rates shoot up, and spreads to U.S. Treasurys narrow, it will become less advantageous for Japanese investors to take on currency risk by investing abroad. That's when U.S. Treasury will be the most vulnerable to selling pressures. This scare hit the market earlier in the year, when JGB yields soared in anticipation of a glut of supply.

Further adding to the supply distress, Japan's Finance Minister Kiichi Miyazawa said on Friday that the government may have to target tax cuts -- which would have an immediate impact on the economy. That worries bond market participants because the cuts, if indeed executed, will have to be funded by issuing more bonds.

Crescenzi sees yields on the benchmark 10-year JGB spurting to 2.5 to 3 percent as issuance kicks in. On Friday, benchmark JGBs closed at a yield of 1.57 percent.

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